The greenback’s charm

Investors remain smitten by the dollar. How much longer will their passion last?

LAST week, at a bank's strategy session ahead of a meeting by the European Central Bank to set interest rates, currency traders weighed up the euro-dollar exchange rate. If the ECB cut interest rates, they decided, the euro would fall, because it would have been pushed by outside pressure and forced to turn a blind eye to inflation. But if the ECB kept interest rates unchanged (as it actually did), traders bet that the euro would still fall, because the bank would be choking European growth. The market, it seems, is so infatuated with the dollar and scornful of the euro that the ECB's policy makes no difference.

The euro duly did fall last week, to below $0.84, within a whisker of its October 2000 all-time low since its launch in January 1999. The dollar has since lost ground, but it still stands roughly 10% higher, against both the euro and the yen, than it did at the end of last year. It is now worth almost 40% more in euros than it was when the single currency was introduced. The dollar's real trade-weighted value (a measure of competitiveness, adjusted for inflation differentials) against 55 developed and emerging-market currencies is at a 16-year high (see chart).

Until last year, the dollar's vigour could be justified by the strength of America's economy, which had attracted large inflows of capital chasing high returns. This explanation still fits the dollar's climb against the yen this year, as Japan's economy is now in recession and America's is still growing, albeit slowly. But the greenback's continued rise against the euro is more of a puzzle.

In its latest World Economic Outlook, the International Monetary Fund tries to explain the movements of currencies over the past decade by analysing all the data. It concludes that the three most important determinants of the dollar's swings against the euro (or against the euro's component currencies before 1999) have been relative expected growth rates, bond-yield differentials and net equity portfolio flows.

On this basis, the dollar should have fallen this year. After all, growth has slowed more sharply in America than it has in the euro area. Last October The Economist's poll of forecasters found that GDP was expected to grow in 2001 by 3.5% in America and by 3.1% in the euro area. Those figures have since been revised to 1.6% and 1.9% respectively. Interest rates have also moved against the dollar. Short-term rates are now lower in America than in the euro area, and the yield premium on American bonds over euro-area bonds has been all but eliminated. Last, but not least, American equities are no longer offering such juicy returns, with the S&P 500 down by 23% from its peak last year.

In recent years America's large current-account deficit has been more than willingly financed by portfolio and foreign direct investment (FDI). But now that American growth has slowed, profits are falling and equities have slumped, why have investors kept their appetite for dollars? Inflows of FDI into America have fallen this year, but portfolio inflows (both equities and bonds) remain strong. America's slowdown has not shaken investors' belief that, over the longer term, America will offer faster productivity growth and hence higher rates of return than Europe.

International investors are still betting on America's “new economy” and the skill of Alan Greenspan, the Federal Reserve chairman. Their belief that Europe remains riddled with rigidities and is unlikely to change much has also been reinforced by recent developments, such as the European Commission's veto of the GE-Honeywell merger and the European Parliament's rejection of an EU-wide takeover code. In the opinion of American currency traders, “Europe still doesn't get it.”

That verdict is somewhat unfair. The single currency is boosting competition and encouraging firms to exploit economies of scale through mergers. With the help of some labour-market reforms, this should lift productivity. However, a study by the Bank for International Settlements finds clear evidence that currency markets react asymmetrically to economic news about the euro. The euro tends to weaken against the dollar in response to disappointing data in the euro area, but fails to rise when the news is favourable. In other words, there is a persistent negative market sentiment towards the euro.

Most currency forecasters still expect the dollar to fall a bit against the euro over the next year, but by much less than they once did. Last December six banks polled by The Economist had an average forecast for the euro-dollar rate of $1.01 by the end of 2001. Their latest average forecast is for a rate of $0.89, and two of the six banks expect the euro to fall to a new low. Even by mid-2002 their average forecast is just $0.93. Only one bank, Goldman Sachs, expects the euro-dollar rate to rise above parity within the next 12 months. Our panel have cut their end-year forecast for the yen even more dramatically, from ¥103 to the dollar last December to ¥126 (see table above).

Wim's wisdom

Most economic studies suggest that the dollar is overvalued against the euro and, to a lesser extent, against the yen. American manufacturers are already squealing, and they are not alone. Sir Edward George, governor of the Bank of England and chairman of the group of G10 central-bank governors, said this week that a strong dollar was hurting not only America but the entire world economy.

In Europe, for instance, the weak euro is pushing up inflation. This, in turn, squeezes real incomes and hence consumer spending, and it is forcing the ECB to delay cutting interest rates. The strong dollar is also putting pressure on emerging-market currencies. Argentina, which pegs its peso to the dollar, faces rising debt costs. Fears about a default are having severe knock-on effects on other emerging economies, such as Brazil (see article). Both in Eastern Europe and in Asia, currencies are tumbling against a strong dollar.

Wim Duisenberg, the president of the ECB, seems however not to believe that a strong dollar is such a threat to the world economy. He said this week that he was not concerned about the weakness of the euro against the dollar. The ECB's critics immediately leapt upon this as evidence that he lives on a different planet.

Yet he may be right. John Makin, an economist at the American Enterprise Institute in Washington, argues that many countries could not cope with a weak dollar on top of a slump in American demand. In a fragile global economy, says Mr Makin, a weaker dollar would be a bigger problem for the rest of the world, as it would let America export more of its recession to others. Japan, in particular, needs a weak yen to fight off deflation. Mr Duisenberg may have been foolish to speak his mind, but that does not mean he was talking nonsense.